Finance academics define risk as volatility, whereas value investors see risk as the probability that adverse outcomes in the future will permanently impair the business's potential cash flow and investor's capital. Which is correct? It all depends on your investment horizon. But if maximizing terminal wealth is of importance to investors, and it is difficult to argue otherwise, then value investors have it right.
Let me explain.
There are two types of fundamental analysts: short-term and long-term. Short-term fundamental analysts are the typical financial analysts. They accept the stock price as given and try to determine what will make the stock price move. Their price targets and investment calls are affected by the release of short-term economic or corporate news. They react to such announcements.
Value investors are long-term fundamental analysts. They do not react to short-term announcements. For example, the short-term noise of whether the next quarter's earnings deviate from expectations is immaterial. What is material for value investors is whether the company continues to have strong fundamentals, be well managed and financially sound, as well as "cheap." The stock price is not important; instead, it is the difference between the intrinsic value and the stock price that is important. If the stock price is significantly below the intrinsic value (by a predetermined margin of safety), then the stock is considered cheap, and value investors buy. Otherwise, they wait.
So, the investment horizon plays a key role in the discussion of what is an appropriate measure of risk. But truly, how much should you worry about short-term volatility? Not much. As Warren Buffett's partner Charlie Munger says, "If you're investing for 40 years in some pension fund, what difference does it make if the path from start to finish is a little more bumpy or a little different than everybody else's, so long as it's all going to work out well in the end? So what if there is a little extra volatility?"
Recent research by Javier Estrada of IESE Business School in Spain bears this out. Mr. Estrada concludes that "investors should learn about the detrimental impact of reacting to short-term volatility and focus on the end game instead." He shows that in the U.S., the mean terminal wealth of investing in stocks over a 10-, 20- and 30-year period is 59 per cent, 146 per cent and 299 per cent higher than investing in bonds. In Canada, the corresponding figures are 41 per cent, 88 per cent and 131 per cent. For the world markets they are 49 per cent, 116 per cent and 231 per cent, respectively.
It is true that the volatility of terminal wealth across all holding periods is found to be higher for stocks than bonds in every market examined and, thus, stocks are riskier when risk is measured by volatility. But interestingly, the higher volatility of terminal wealth from stocks is mostly on the upside. So, stocks have both higher upside and more limited downside than bonds.
Why, then, are stocks considered riskier than bonds? It may be the wide acceptance of volatility as a measure of risk at universities and academia's influence on professional designations for investors.
There could also be another reason. In a perfect world, both the investor and the mutual fund manager will have a long-term horizon, and volatility would play no important role. But what if the investor has a short-term horizon and panics in the face of short-term volatility? In this case, the mutual fund manager will have to consider short-term volatility if he does not want to lose funds under management and possibly his job. He will have to abide by the desires of the investor and also focus on short-term volatility, contributing to the focus of the mutual fund industry and financial analysts on the short term.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.